Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Reexamining the Empirical Relation between Loan Risk and Collateral: The Roles of Collateral Characteristics and Types

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Reexamining the Empirical Relation between Loan Risk and Collateral: The Roles of Collateral Characteristics and Types

Article excerpt

Abstract: This paper offers a possible explanation for the conflicting empirical results in the literature concerning the relation between loan risk and collateral. Specifically, we posit that different economic characteristics or types of collateral pledges may be associated with the empirical dominance of the four different risk-collateral channels implied by economic theory. For our sample, collateral overall is associated with lower loan risk premiums and a higher probability of ex post loan nonperformance (delinquency or default). This finding suggests that the dominant reason collateral is pledged is that banks require collateral from observably riskier borrowers ("lender selection" effect), while lower risk premiums arise because secured loans carry lower losses given default ("loss mitigation" effect). We also find that the risk-collateral channels depend on the economic characteristics and types of collateral. The lender selection effect appears to be especially important for outside collateral, the "risk-shifting" or "loss mitigation" effects for liquid collateral, and the "borrower selection" effect for nondivertible collateral. Among collateral types, we find that the lender selection effect is particularly strong for residential real estate collateral and that the risk shifting effect is important for pledged deposits and bank guarantees. Our results suggest that the conflicting results in the extant risk-collateral literature may be because different samples may be dominated by collateralized loans with different economic characteristics or different types of collateral.

JEL classification: G21, D82, G38

Key words: collateral, asymmetric information, banks

1. Introduction

Collateral is a prominent feature of debt contracts, but the underlying motivation for collateral is not well-understood. Economic theory generally explains collateral as an attempt to reduce agency costs or contracting frictions in the presence of asymmetric information. One strand of theory motivates collateral as part of an optimal debt contract by invoking ex post frictions, like moral hazard, and predicts that observably riskier borrowers are more likely to be required to pledge collateral. (1) A second set of theories focuses on ex ante private information and suggests that collateral may allow lenders to sort observationally equivalent loan applicants through signaling. (2) Specifically, lenders offer a menu of contract terms such that observationally equivalent applicants with higher-quality projects choose secured debt with lower risk premiums, while those with lower-quality projects self-select into unsecured debt with higher risk premiums.

To test these theories, a number of studies link measures of loan risk--such as loan risk premiums or ex post nonperformance--to whether or not collateral was pledged for a given credit. Some studies report a positive relationship between loan risk premiums (loan rates less the risk-free rate) and collateral pledges (e.g., Berger and Udell, 1990; Blackwell and Winters, 1997; Machauer and Weber, 1998; John, Lynch, and Puri, 2003; Brick and Palia, 2007; Godlewski and Weill 2010), while others find a negative relationship (e.g., Degryse and Van Cayseele, 2000; Lehmann and Neuberger, 2001; Agarwal and Hauswald, 2010; Berger, Frame, and Ioannidou, 2011). (3) In addition, two studies find that ex post nonperformance of loans (delinquency or default) is positively related to collateral pledges (Jimenez and Saurina, 2004; Berger, Frame, and Ioannidou, 2011).

To our knowledge, there are no attempts to explain this puzzle in the literature--why the empirical relation between loan risk and collateral is sometimes positive and other times negative. This paper provides a potential solution to this puzzle by examining the relations between risk and the economic characteristics and types of collateral--each of which may be associated with the empirical dominance of different risk-collateral channels implied by economic theory (outlined below). …

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